Whether in the private sector or government, a debt crisis in one country can and frequently does spread economic pain to other countries. This can happen through a tightening of financial conditions such as a spike in interest rates, a slowdown in trade and economic growth, or merely a steep decline in confidence. This is especially true if the country in crisis is large and intricately linked to the global economy.

A debt crisis can lead to steep losses for banks, both domestic and international, perhaps undermining the stability of financial systems in both the crisis-hit country and others. This can hit economic growth as well as create turmoil in global financial markets. If a country's debt crisis is severe enough, it could result in a sharp economic slowdown at home that drags on growth elsewhere.

Key Takeaways

  • Financial losses, market turmoil, and sharp slowdowns in trade and economic growth are some of the ways countries can feel the effects of a debt crisis in another country.
  • Even in a small country, a debt crisis can have devastating effects elsewhere if that country is enmeshed in the global financial system and economy.

Global Financial Crisis

The 2007-08 global financial crisis showed how a debt crisis can spread like an epidemic and hurt economies worldwide. Though other countries participated in similarly risky behavior—particularly in Europe—the global financial crisis was essentially made in the U.S., with risky lending in the sub-prime mortgage market and extremely leveraged derivatives trading on Wall Street.

Because the U.S. has the world's dominant economy and financial system, and because so many economies around the globe depend on the health of the U.S. economy, the fallout was widespread and severe, causing market slumps worldwide and a global economic recession. Fear of a complete economic collapse made consumers unwilling to buy and banks unwilling to lend, accelerating a downward economic spiral in the U.S. that quickly spilled over to other economies.

Asian Financial Crisis

The case of Thailand and the Asian financial crisis shows that even a debt crisis in a smaller country that is closely linked to the global economy can wreak havoc in other nations. That crisis was triggered when Thailand’s financial imbalances—quickly rising external debt and a reliance on short-term inflows of foreign capital—caused the government to devalue its currency, the baht. The result was a collapse in the currency, which left Thailand unable to pay many of its foreign creditors.

The problem quickly spread to other Asian countries, especially in Indonesia and South Korea. Other regional currencies fell due to expectations that Thailand's export competitors would also be forced to devalue their currencies, making it more difficult for borrowers of foreign capital to pay back their debt. Interest rates surged as nations tried to slow the outflows of capital, bringing economic growth to a halt.

In 1998, real per capita gross domestic product fell by 16% in Indonesia, 12% in Thailand, and 8% in South Korea.